Virtual/Network Organizations

Virtual Organizations

A firm that contracts out almost all functions. The only
function retained by the organization is the name and the
coordination among the parties. A virtual organization might not
have even have a permanent office.

Especially common in the fashion industry where you can have
clothing labels that are just that. Say the label is "John Taylor". The label has a clear identity in the public eye,
but when you try to track down the John Taylor company, you find
there are no John Taylor designers, no John Taylor manufacturers.
It's just 3 people in an office subcontracting out all functions.

It is a network of firms held together by the product of the
day. An open-ended system of ideas and activities and firms.

Network Organizations

A network organization is a collection of autonomous firms or
units that behave as a single larger entity, using social
mechanisms for coordination and control. The entities that make
up a network organization are usually legally independent
entities (separate firms) but not always. Some of the entities
may be wholly owned subsidiaries. They can even be divisions
within the company, but treated as separate companies that sell
to outside customers.

For the purpose of discussion, it is convenient to distinguish
three types of network organizations: internal, stable, and
dynamic.

Internal Network

Large company that sees its units as separate profit centers.
It may encourage the units to sell its products outside the
company as well (e.g., GM and its spark plug division). One
reason for doing this is the belief that if units have to operate
with prices set by the market, they have incentive to improve
performance and reduce prices.

In these organizations, corporate headquarters acts like
broker. A bit like role of government in business in Japan.

Stable Network

The stable network consists of a central organization that
outsources much of its operations to other companies. For
example, at BMW, they outsource about 65% of the total production
cost of a car.

The central organization often has longterm relationships with
suppliers, who have access to the company's computer system and
may be present at private planning sessions. The central
organization may also have several joint ventures, alliances,
long term contracts, etc. going with different companies.

Dynamic Network

The dynamic networks outsource even more heavily. Basically,
an integrator firm identifies and assembles assets owned by other
companies. Typically, the integrator is a downstream player whose
core competence is understanding the market. For example, Nike is
the center of a dynamic network. Their only functions are R&D
and Marketing.

Dynamic networks are common in the fashion, toys, publishing,
motion pictures, and biotech industries.

Market Networks

There may exist a fourth type of network organization, which
we might call the "market network". These organizations
don't have a lead player that coordinates the others. Instead, a
collection of organizations trading in the market fall into a
stable pattern of relationships that gradually becomes
solidified. Initially, members of the network may not be aware
that they have fallen into this pattern. We can think of these
organizations as natural "subassemblies of the
economy.

Comparative Advantage of Network Organizations

The first question to ask is, What are the alternatives to
network organizations? There are two basic alternatives:
vertically integrated firms, and the open market. How do firms
decide what functions to perform in-house, and which to purchase
on the market? Why aren't all functions purchased on the market?

Transaction Cost Analysis

Think about a firm that makes a product based on a certain
kind of computer memory chip. They buy the chips on a recurring
basis from a few different suppliers. Demand for these chips
varies widely from time to time so availability and prices are
never givens. Also, there are wide variations in quality because
the silicon wafer technology has not yet solved some basic
production problems. Every batch of chips purchased has to be
scrutinized carefully, and bad chips have to be sent back and
replaced. The variations in availability and price force the
company to overbuy and then maintain warehouses full of supplies
so that their assembly lines do not have to be shut on and off
with variations in the chip market. By maintaining a lot of
inventory, they can buffer their core technological processes,
doling out the chips in a measured, reliable stream. The trouble
is, maintaining a lot of inventory is expensive, especially when
the chips change over time and old chips are made obsolete.

The problem is even worse when the company needs specialized
chips from their suppliers, custom products that they have
designed themselves. Or, the other way around, each chip company
does things differently, and the manufacturer has to adapt their
designs to specific chips (the way operating systems are built
for specific families of processors).

Under these conditions (frequent transactions, uncertainty of
supply, and customization) organizations will elect to bring the
process in-house. That is, they will vertically integrate. The
reason is that contracting with outsiders under these conditions
is costly. There are costs in maintaining inventories, costs in
monitoring the exchanges for malfeasance, costs in searching for
suppliers, costs in specifying legal contracts, etc. Furthermore,
because they are working with this custom product, there are no
other sources of supply that are ready-made. So they could be
charged a premium price.

In contrast, for functions that do not require frequent
exchanges, that do not suffer from uncertainty of supply, and
which do not require customization, organizations will contract
with outside firms, because it will be cheap enough to do that.
The costs of making and monitoring the transactions themselves
will not be prohibitive, which allows the organization to take
advantage of hiring specialists to do the job. These specialist
firms can deliver a higher quality product, and can often do it
more cheaply because of the volume they do. According to economic
theory, in a perfect competitive market, it is always better to
hire out a function unless the transaction costs make that too
expensive.

What Conditions Favor Network Organizations

Network organizations are a blend of market and firm. They are
halfway between vertical integration and market disaggregation.
The conditions that favor network organizations are:

Frequent transactions. Infrequent exchanges are best
negotiated on the market.

Demand Uncertainty. Not to be confused with supply
uncertainty. Demand uncertainty refers to the inability to
predict how well an organization's products will sell. For
example, the film industry suffers from the inability to predict
which films will make it and which won't.

Customization. Also known as asset specificity, exchanges that
involve individually customized products or services.

Task Complexity. How complicated is the product being created.

Structural Embeddedness. The extent to which firms (and their
members) are related to each other via a host of ties, so that
information about each other is always flowing. This helps to
coordinate and control the firms.

As you can see, most of these conditions are the same as those
favoring firms rather than markets. Network organizations are
more like firms than markets. But they occur in situations where
demand uncertainty makes vertically integrated firms a bad idea.
When technology and markets are changing fast enough, it doesn't
make sense for a company to invest in a whole division because
when things change they are stuck this whole infrastructure that
is now obsolete. So they decouple -- taking the highly volatile
sections out. Yet, because of all the other conditions, they need
to maintain control, so they don't just hire it out on the
market.

A network organization is like an ordinary firm which does not
have a system of direct supervision, nor standardized rules and
procedures that apply throughout the firm. Consequently, they
have to coordinate and control the units in some other way. Some
of the ways they do this are:

Joint payoffs. Networks are organized around specific products
or projects. Payments for work are arranged based on the final
product, so that if the product doesn't make it, nobody gets any
money. This provides incentives for everyone to do their best.

Restricted access. By definition, network organizations do not
hire just anybody on the market. Instead, they restrict their
exchanges to just a few longterm partners. This makes the
organizations more dependent on each other, so that their is more
cost in defaulting. In addition, but increasing the probability
of future exchanges, this creates the conditions for avoiding a
bad deal now so as to get future rewards. (If I take advantage of
you on this deal, I'll make out like a bandit, but I'll never get
work from you again, so I forgo all that future money.)

Reputation. In the film industry, everyone talks to everybody.
If someone is difficult to work with, or doesn't pull their
weight, everybody hears about it and it affects their ability to
get future jobs.

Macroculture. The existence of a common industrial culture
greases the wheels for coordination. Everybody speaks the same
language, has similar expectations and understandings of the
task, so more can be implicit rather than explicit.